To beta or not to beta, that is the question

Following the collapse of Lehman Brothers in September 2008, I remember addressing the more junior members of EG's investment team, reassuring them about their job security and adding: "It may not feel like it right now, but you're very fortunate to experience such a major correction so early in your career. What you will learn over the next few years has the potential to turn you into an expert investor and can set you up for life."

I then asked the team to perform an analysis of the likely impact of the global financial crisis on individual asset values in EG's portfolio at the time.  What was immediately apparent was that "assets are not created equal" when it comes to their response to an economic shock.  

Most of EG's assets we estimated would fall by about 20-30% in capital value from peak to trough, but one asset (located in Bunbury, 150kms south of Perth, WA) we expected would fall in value by as much as 50%. 

What accounted for this massive difference and how could we more accurately price this exposure in the future? 

Real estate assets it turned out - much like listed stocks - exhibit different "beta" scores.  Beta in the investment literature refers to the correlation of an individual asset's return relative to the market return. A beta of 1.0 means an asset moves in line with the market. A beta of 1.5 means an asset will outperform the market by 50% in the event the market rises, and conversely that it will underperform the market by 50% in the event the market falls.

Remarkably, the Bunbury asset exhibited a beta score of 2.0. It fell in value by twice as much as the general market.  This was clearly a big deal and we realised immediately that we needed to measure and price this risk on acquisition. 

From that day onwards we introduced a mandatory "beta risk" module into our risk management software, PRISMS? - a module we now affectionately refer to as the "Bunbury Amendment". 

EG now assigns a beta score to each real estate asset prior to acquisition. We look at seven criteria including location, quality of the improvements, WALE vs term of investment, strength of covenant, tenant concentration risk, exposure of tenants to business risk and likely depth of market on exit. Each of these criteria are graded according to a scale that we have devised, which PRISMS? then uses to generate an estimate of the asset's beta.

And although real estate asset betas cannot be precisely quantified - EG takes the view that it is better to be approximately right (and estimate it) than to be precisely wrong (and ignore it).

We are the only real estate investment shop that I know of that assigns a beta to each and every real estate asset we assess.  

I often get asked if it's really worth all that effort? 

I answer thus: after almost 15 years of commercial real estate investment spanning the global financial crisis, I'm proud to say that EG is yet to record a negative realised return on a single asset (let alone a fund). It is a record we are prepared to work assiduously to defend. 

Betas now play a vital role in helping EG to avoid acquiring volatile assets in periods when timing risk is high.  

Not exactly a subject worthy of a Shakespearean soliloquy but, for EG at least, the answer is "to beta".

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Adam Geha is CEO and co-founder of EG, a leading fund management group that has significantly out-performed its peers through an uncompromising commitment to alignment and its proprietary risk management system (PRISMS?).

 To find out more, visit: www.eg.com.au or connect with Adam on LinkedIn or follow on Twitter.

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Real Estate is a network asset
Which road leads to greater riches, Location vs Timing?
Three Things you need to know about your Fund Manager (part 1)
Three Things you need to know about your Fund Manager (part 2)

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